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For release on delivery Statement by William McChesney Martin, Jr. Chairman, Board of Governors of the Federal Reserve System before the Joint Economic Committee February 14, 1968 I appreciate the opportunity of meeting again with this Committee to discuss the state of the economy. It was just about a year ago that we last met, then in a quite different economic context. At that time, economic activity was faltering; businessmen were adjusting production schedules to reduce excessive inventories, investment in new plant facilities was falling and consumer spending for durable goods was declining. Many doubted that the economy had sufficient resiliency to absorb a massive adjustment of inventories without a serious recession. Today we meet in a far different situation. The economy is advancing at a rapid pace, labor resources are under strain, and costs and prices are moving up swiftly. In short, we are in the midst of inflation. The avoidance of recession in 1967--the fact that we experienced only a pause, and not a reversal in economicexpansion— was, in large measure, the result of prompt and vigorous application of the tools of stabilization policy. As early as the fall of 1966, when it first became evident that pressures in the economy were abating, monetary policy shifted away from restraint and toward ease. Throughout the first half of 1967, policy provided a monetary climate that facilitated the orderly adjustment of business inventories and the recovery in home building activity. stimulative. At the same time, fiscal policy became increasingly The rise in Federal spending was maintained, and the Federal deficit in the first half of 1967 reached the highest level since World War II. -2- The combined monetary and fiscal stimulus helped the economy to absorb a major decline in inventory investment, from a rate of over $18 billion in the fourth quarter of 1966 to less than $1 billion in the second quarter of 1967, with minimal effects on production and employment. Industrial output dropped by less than 3 per cent over the first half of the year, and unemployment remained below 4 per cent for most of the period. The resilience of our economy, and the timely use of stabilization policies, were amply demonstrated in the first half of 1967. Unfortunately, there is less reason to be proud of the performance of the economy, or of stabilization policies, since mid-1967. The zeal with which policies were adapted to deal with a flagging economy has not been matched by commensurate zeal in coping with the emergence of economic overheating. The continuing large Federal deficit, in a period of rebounding private demands on resources, has intensified the strains on markets for labor, commodities and financial capital. Since the middle of last year, prices have risen at about a 4 per cent annual rate, almost twice as rapidly as earlier in the year. With labor markets tight—unemployment has fallen to the lowest levels since the KoreanWar— the rise in prices is being translated into wage demands about twice as large as the long-run gains in productivity. And the rise in our costs and prices has been an important factor in aggravating an already serious balance of payments deficit. The resurgence in economic activity and in inflationary pressures after midyear-1967 did not come as a surprise. Anticipating -3— these developments, early in the year the President recommended a fiscal program to insure that the rebound in activity would not reach an excessive pace. In my appearance before this Committee a year ago, I urged the immediate adoption of the President's proposals, in order that the Government could enter the period of renewed expansion in an appropriate fiscal posture. Delay in getting our budgetary deficit under control has been costly. The failure to exercise prudence in fiscal management before the forces of inflation gathered momentum has resulted in major setbacks in achieving both our domestic and our international economic goals. Even now, with costs and prices advancing rapidly, we still are hesitating about taking tax measures to restrain demands. Some fear that demand restrictions cannot curb an inflation stemming from "cost-push". Others argue that nothing should be done about the current inflation, because a recession lurks around the corner. Let me address myself first to the economics of cost-push and demand-pull. It seems to me that cost and price developments last year demonstrated once again how cost-push and demand-pull pressures interact to produce inflation. In the first half of 1967, costs rose rapidly, as wages continued to rise, and with production dipping, overhead costs had to be spread over a smaller output. Unit labor costs in manufacturing, for example, increased at an annual rate of almost 51/2per cent, about twice as rapidly as in the preceding year. Nevertheless, with overall demands leveling off, the rise in costs was -4not translated into higher prices. Industrial commodity prices were stable from February through July, and the advance in consumer prices slowed significantly. But with the resurgence in aggregate demands after midyear, prices responded rapidly, even though the rise in unit labor costs moderated as production facilities began to be used more intensively. As soon as markets improved, past—and, indeed, prospective—cost increases were passed through the structure of production and distribution. The swift pace at which aggregate demands rose in the third and fourth quarters of last year provided a climate in which costs could more easily be passed on in the form of higher industrial and consumer prices. The rise in prices has fueled higher wage demands, laying the groundwork for another round of cost increases. And as long as overall demands continue to rise too rapidly, further cost pressures will be reflected in further increases in prices of industrial and consumer goods. As for the issue of the economy's capability of absorbing a tax increase, even a cautious appraisal of economic prospects suggests a continued increase in demand pressures this year. The basic strength of expansionary forces in the economy has become evident since the termination of major work stoppages. For a few months, earlier in the fall, strikes in the auto and other industries had held back the recovery in production and sales, resulting in economic statistics that appeared to buttress the case of those who saw more weakness than strength in the economic outlook. When production rebounded -5- at the end of the strikes, attention shifted to the apparent sluggishness of retail sales around the Christmas period. The latest figures, however, reveal that consumer spending is picking up rapidly, and unemployment has fallen sharply. Now attention is shifting to the possibility of weakness developing next summer. At any point in time, there will be some economic measures out of joint. And there will always be legitimate concern about the economic future. Forecasting economic developments is still an art, not yet a science, and no one can pretend to certainty about the outlook. At this point in time, however, the great weight of the evidence is on the side of expectations for continued strong expansion in demands. Even if consumers should continue to save a high proportion of their after-tax incomes, consumer spending would rise substantially as incomes accelerate. Some reduction in business inventory accumulation is likely next summer, particularly in the stockpiling of steel. But the adjustment in steel inventories after the conclusion of wage negotiations in 1965 had little effect in retarding expansion then, and there is no more reason to expect a serious impact on overall economic activity from this source in 1968. Moreover, even with a tax increase and restraint on Government spending, the Federal budget would still be providing a significant net stimulus to the economy. We need no splurge in retail sales, or boom in investment spending, or excessive run-up in business inventories, to avert a recession this year. -6- Indeed, the greater risk is that expansionary forces will accelerate too rapidly and add further to inflationary pressures. Consumers' spending propensities are more likely to rise than to fall, as incomes accelerate and the workweek lengthens. Business plans to increase capital outlays, now modest, are more likely to be revised upward than downward, if the increase in final demands and in prices continue untrammeled. And, as Budget Director Zwick noted to this Committee last week, the risks are obviously in the direction of higher, rather than lower Federal spending, particularly in light of recent developments in the Far East. The risks, therefore, are almost all on the side of too much demand, rather than too little. And the greatest danger to sustained expansion throughout the year is not that the economy might be too weak to absorb a tax increase, but that inflation will result in the excesses and distortions that inevitably lead to economic setbacks. A failure to exercise firm fiscal restraint will create an economic climate conducive to excessive inventory building and excessive plant expansion, only to be followed by cutbacks in output and employment as businessmen have to restore balance in their stocks, labor force and capacity. It will encourage inflationary wage settlements that can be accommodated only by further price increases, diminishing both the potential for domestic sales and the possibility of regaining export markets, while attracting imports of foreign goods. And if the Government is forced to continue borrowing vast sums in financial markets to finance another -7large deficit, the availability of funds to sustain home building at a high level will be seriously curtailed. The financing of home construction is in a somewhat better position to compete for funds than in 1966, for the liquidity position of thrift institutions improved considerably last year. But home financing cannot be insulated from strong financial market forces. The pressure of corporate and Federal financing demands has already begun to pinch the flow of funds to mortgage lenders. Savings inflows at thrift institutions have been reduced, growth in the volume of commitments for future mortgage lending has slowed appreciably, and interest rates on mortgages have returned to the peaks of 1966. Increases in the cost of mortgage financing and mounting pressures on the availability of mortgage funds recurred last year even though monetary policy remained expansive through the summer and early fall. Monetary ease was maintained, despite the reemergence of inflationary pressures during the summer, to avoid a premature curtailment of the recovery in housing and aggravation of the strains in domestic and international financial markets resulting from the record volume of Treasury borrowing accompanied by a record volume of capital market financing by corporations and State and local governments. Moreover, the fiscal restraint program submitted by the President in early August offered the best prospect of relief from the tensions developing in financial markets and from the inflationary effects of growing demand pressures on real resources. -8- But with fiscal restraint held in abeyance, with inflationary pressures accentuating following termination of strikes in the auto and other industries, and with pressure on the international position of the dollar mounting after the devaluation of sterling, a shift was made later in the fall to a less expansive monetary policy. step — a Britishdevaluation— The initial one-half point increase in the discount rate following the was a modest precautionary move in a situation of grave uncertainties; in fact, some in the System expressed a preference for a larger move to restraint at the time. In December, as prices continued to advance rapidly, gold losses mounted, and our international trade balance diminished, an increase in member bank reserve requirements was announced and open market operations were adjusted to support this less expansionary policy. These moderate moves toward monetary restraint were initially accompanied by some easing of tensions in financial markets, partly as a result of seasonal and other temporary factors. More recently, however, pressures have returned to financial markets, interest rates on market securities have been rising, and the flow of funds to institutions specializing in housing finance is once again being threatened. In the absence of fiscal restraint, it may well prove impossible to avoid a contraction in the availability of credit to those sectors of the economy least capable of withstanding competitive pressures for funds. Housing finance, in particular, continues to be -9- hampered by rigidities and imperfections that cannot swiftly be removed, and difficulties could be faced by many municipal and small business borrowers. Financing a continuing large Government deficit would absorb a disproportionate share of financial savings. And with real resources strained, prices increasing, and our balance of payments in difficulty, monetary policy could not irresponsibly permit the creation of credit on a scale that would accommodate all the private financing demands that inflation would generate. To permit inflationary pressures to continue unchecked would dissipate the opportunity that the new balance of payments program is intended to provide, namely, the time to effect fundamental corrections in our position. How much we need an improvement in our international competitiveness was illustrated dramatically by the behavior of the U.S. trade balance during 1967. The rise in imports had halted in early 1967, as aggregate demands in our economy leveled off, but with the resurgence in activity, imports spurted to a new high by year-end. For the year as a whole, our merchandise imports were up 51/2per cent over the preceding year, and almost half again as large as in 1964. Our exports last year did not do as well as we had hoped they would. They rose only 41/2per cent for the year as a whole, and actually declined in the last quarter. Our merchandise trade balance, which had reached nearly $7 billion in 1964, dwindled to less than $4 billion in 1967. -10- Factors operating to dampen the demand for our exports were particularly important lastyear— such as the recession in Germany and the effects of the slack conditions in leading European countries on demands in many parts of the world. It is gratifying, therefore, that several European countries are using monetary and fiscal policies aimed at encouraging domestic expansion. Growth in economic activity and maintenance of relatively easy credit conditions in Europe are vital complements to the President's program to reduce the United States balance of payments deficit. But economic expansion abroad will not, by itself, be sufficient to produce a better balance in the pattern of international payments. We must temper the rise in demands here, in order to avoid surges in imports and to keep our exports competitive. Serious as is the deterioration in our international trading position, it was on the capital side of the payments balance that worsening was most acute last year. Shifts in capital flows accounted for most of the change from a balance of payments deficit of about $11/2billion in 1966, on the liquidity basis, to one of about $3 1/2 billion in 1967. In 1966, an unusual constellation of factors had held down the net outflow of capital. Taut financial market conditions in this country pulled in a large amount of foreign private liquid funds in 1966. There was still a net inward flow of such funds in 1967, but not on so large a scale, and there was a moderate outflow of bank -11loans and credits last year, reversing the inflows of such funds in 1965 and 1966. Also, net liquidation of foreign equity securities by United States investors, in response to the IET, came to an end in 1967. Thus, after the temporary favorable circumstances affecting capital flows in 1966 were gone, a large overall deficit reemerged in 1967. In the context of a large and persistent deficit in the U.S. balance of payments, the devaluation of sterling last November unsettled gold and foreign exchange markets. Nevertheless, we have no evidence of any large flight out of dollars into either gold or foreign currencies. In fact, foreign private holdings of liquid dollar assets in the United States continued to show a net increase during the fourth quarter of 1967. A great deal of the purchasing of gold in recent months was done, we think, by people who were shifting out of sterling or out of continental currencies, rather than out of dollars. Over the longer pull, however, we cannot depend on retaining the confidence of foreign holders of dollar assets unless we conduct our economic affairs in such a way as to deserve confidence. The new balance of payments program announced on New Year's Day by the President is addressed principally to reducing certain types of capital outflows, particularly direct investment outflows and bank lending. such restrictions on particular types of international transactions cannot be relied on in the long run to assure sustained equilibrium in the overall U.S. payments position. Public and private restraint But -12- in demands on our resources will be an essential element in the success of the United States in correcting its balance of payments problem. To Summarize this brief review of the key developments and problems in public policy formulation over the past year, it is clear that we have, as a Nation, greater readiness to combat recession than to cope with inflation, despite the grave consequences that failure to restrain inflation could have for our economy, both domestically and internationally. The Congress should act now to provide the fiscal restraint we need to sustain a balanced expansion and to protect the value of the dollar at home and abroad.
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